guideline for accounting for current costs and …

RAG 1.03 Revised January 20031

GUIDELINE FOR ACCOUNTING FOR CURRENT COSTS ANDREGULATORY CAPITAL VALUES

REGULATORY ACCOUNTING

GUIDELINE 1.03

Operative: Financial Year 2002-03

��Issued May 1992Revised January 2003


Contents

Part 1 Explanatory note 3Introduction 3Licence Authority 3Objectives 4Infrastructure renewals accounting 4Profit measurement 5Real financial capital maintenance 6Asset valuation principles 7 Valuing new investment 8Assets existing at 31 March 1990 10Infrastructure assets 11Current cost profit and loss account 13Regulatory capital values 16Limitations on use 18

Part 2 Definition of terms 20

Part 3 Accounting guideline 23

3.1 Scope 233.2 Current cost balance sheet 23

Infrastructure assets 24Operational assets 25Other tangible assets 26Third party contributions since 31 March 1990 26Reserves 27

3.3 Current cost profit and loss account 27

Adjustments to HC operating profit 27Financing adjustment 27Exceptional items 27Extraordinary items 28

3.4 Content of accounts 28

3.5 Regulatory capital value 28

Appendices

1 Worked example 322 Assumptions made in RAG 1.03 403 Current cost accounting policies 424 Acronyms 445 Bibliography 45


Part One – Explanatory note

1.1 Introduction

1.1.1 This explanatory note discusses the objectives of the requirements for currentcost (CC) accounts, the rationale behind the form of modified real termsaccounting required and the limitations on the uses and interpretation of theaccounts in their present form.

1.1.2 It also flags various simplifications being adopted in these guidelines forapplication of the principle in the water industry. Most of the simplificationsare based on an assumption of immateriality. If for a particular company anyof these simplifying assumptions are not immaterial, then more accurate profitadjustments may be appropriate. Some of the simplifications may be refinedafter further research; in these cases future guidance will be given on thetreatment of the effect of refining the simplifying assumptions.

1.1.3 Also included in this section, is an explanation of the regulatory capital value(RCV) that should be disclosed by way of a note to the current cost accounts.Although the asset valuation used in the CC accounts remains that of ModernEquivalent Assets, the disclosure of RCVs is important since the calculationof the RCV is an essential element in Ofwat’s price determination process.

1.1.4 Part 2 defines terminology. The formal guidelines on Current Cost Accounting(‘CCA’) are set out in Part 3. Appendix 1 sets out an illustrative example ofthe application of the guidelines. Appendix 2 lists the simplifying assumptionsbeing made and Appendix 3 contains a recommended statement of CCApolicies. Appendices 4 and 5 give acronyms used and a short bibliography.

1.2. Licence authority

1.2.1 Paragraph 8 of Condition F of the Licence requires Appointees to prepareCCA statements in addition to historical cost accounting statements inaccordance with guidelines notified by the Director General.

1.2.2 These guidelines may:� specify the form and content of CCA statements;� require reconciliations between the CCA statements and the historical

cost statements;� specify the accounting principles and the basis of calculation to be used in

preparing CCA statements; and � specify the nature of the auditor’s report required in respect of CCA

statements.

1.3 Objectives

1.3.1 The general objective of Ofwat in issuing these revised guidelines is forcompanies to publish accounting statements which will be consistent with theeconomic framework in which they are regulated. More specifically, Ofwat isseeking to achieve the following objectives:


� to provide a comparable measure of the real costs of supply, including thecost of capital, across companies;

� to provide realistic measures of asset values and the trends in the returnsearned on these assets.

� to promote transparency of regulation by publishing regulatory capitalvalues (RCVs); and

� to promote transparency of costs.

1.3.2 These guidelines on CCA will provide Ofwat with measures of total real costsand of trends in the real rates of return that are suitable for comparativepurposes. Limitations upon the interpretation and uses of the CC accounts inthe water industry are the subject of paragraph 1.13 below. Basically a formof modified real terms accounting is adopted. Profit is measured in real termsbut initial assets are valued at replacement cost. This replacement cost willbe above the economic value (the present value of the net revenues arisingfrom these assets) and hence the "fair" value, such as would be used inacquisition accounting. Accordingly the absolute rates of return shown are ofvery limited significance. The rate of increase in profit reflects the cost ofcapital on new investment and the total costs of output have to be adjusted toinclude the normal costs of capital. The rate of return allowed by Ofwat insetting price limits is a return on the RCV and is reflected in the revenueswhich companies charge. The RCV is often used by the investmentcommunity and others as a proxy for market value. The rate of return on theRCV is therefore more widely used and a better understood measure than thereturn on the replacement cost of the assets. The inclusion of the RCV in theaccounts will allow users to assess this return themselves.

1.4 Infrastructure renewals accounting

1.4.1 Historical cost accounts ('HCA') are recognised universally as a legitimatemethod of financial reporting but have a variety of limitations, in particular inregard to the return on capital earned in capital intensive industries with longasset lives such as the water industry. In the presence of inflation theselimitations typically lead to:- understated asset values;- overstated profit measures; and consequently- overstated returns on capital and distorted measures of total costs which

persist even if inflation falls to zero.

1.4.2 The adoption of infrastructure renewals accounting by the industry overcameonly in part such limitations of traditional HCA for infrastructure assets.

Infrastructure renewals accounting is used for long-life network assets (calledinfrastructure assets). It effectively regards the whole quantum of individualassets as a single infrastructure asset. Infrastructure renewals accounting isbased on an operational assessment of activity needed to maintain theserviceability of the underground infrastructure over a reasonably long period(typically in excess of 15 years).

1.4.3 These guidelines on Current Cost Accounting (CCA) build on infrastructurerenewals accounting and will provide Ofwat with measures of total real costsand of trends in the real rates of return that are suitable for comparative


purposes. In recent years, the Accounting Standards Board has issuedFRS12 - Provisions, contingent liabilities and contingent assets (effectivefrom March 1999) and FRS15 – Tangible Fixed Assets (effective from March2000). Both these standards are to be dis-applied for infrastructure assets forregulatory accounts purposes. As a result of the dis-application, a fullreconciliation between the statutory accounts and the historic cost regulatoryaccounts should be included within the regulatory accounts in accordancewith Appendix 2 of RAG3.05. Guidance on this matter was previously given inRD11/00 ‘Regulatory accounts for 1999-2000 Reporting Requirements: RAG3.04’ (6 April 2000).

1.5 Profit measurement

1.5.1 The ASC Handbook on 'Accounting for the effects of changing prices' (1986)discusses two alternative measures of a company's profits which can besummarised as follows:

� Real Financial Capital Maintenance ('FCM’) is concerned withmaintaining the real financial capital of a company and with its ability tocontinue financing its functions. Under real FCM, profit is measured afterprovision has been made to maintain the purchasing power of openingfinancial capital. This involves the use of a general inflation index such asthe RPI. Real FCM therefore addresses the principal concerns of theshareholders of a company. In the absence of general inflation real FCMis equivalent to conventional HCA, with the exception of the treatment ofunrealised holding gains (paragraph 1.8.11).

� Operating Capability Maintenance ('OCM') is concerned with maintainingthe physical output capability of the assets of a company. Under OCM,profit is measured after provision has been made for replacing the outputcapability of a company's physical assets which involves the use ofspecific inflation indices such as the Construction Price Index (COPI) orthe Baxter index. This will typically be a major concern for themanagement of a company and was the approach used in Statement ofStandard Accounting Practice ('SSAP') 16 – Current Cost Accounting(this standard was withdrawn).

1.5.2 The Statement of Principles for Financial Reporting (December 1999)discusses measurement in financial statements (Chapter 6) of assets orliabilities. The Statement recognises that whilst the financial capitalmaintenance (FCM) concept approach is satisfactory under conditions ofstable prices it is open to criticism when there are substantial general orspecific price changes. There is no evidence looking over a period of timethat the industry has experienced specific price changes, accordingly the RPIremains the best measure of price changes overall. The linkage for the waterindustry between revenues charged under the RPI + K regime and generalprice increases in costs negates the criticism about the FCM approach wherethere are substantial general price increases.


1.5.3 The Water Industry Act 1991 sets out the Director’s primary duties as follows:

Part I Section 2(2)

(a) to secure that the functions of a water undertaker and of a sewerageundertaker are properly carried out as respects every area of Englandand Wales; and

(b) with out prejudice to the generality of paragraph (a) above, to secure thatcompanies holding appointments under Chapter I of Part II of this Act asrelevant undertakers are able (in particular, by securing reasonablereturns on their capital) to finance the proper carrying out of the functionsof such undertakers.

Following discussions with the Working Group on Accounting Issues forRegulation (‘WGAR') in 1991, it was decided that the regulatory CC accountsshould be prepared on a real FCM basis since this provides a measure ofprofit that is well suited to achieving a balance between the providers ofcapital and customers.

1.5.4 The Director also has a duty to ensure that the companies maintain therequired level of physical operating capability. The June returns to theDirector, on the level of service and capital expenditure, are howeverspecifically designed to monitor operating capability plans against requiredservice standards, and the Director concluded that there is no need to reflectOCM concepts in the CC accounts.

1.6 Real financial capital maintenance

1.6.1 In a normal competitive environment, it is usual for the accounts to focus onthe returns to shareholders. Under real financial capital maintenance, profit isdefined to be the increase in purchasing power of shareholders' funds,allowing for the introduction and withdrawal of capital, including dividends.The RPI is generally used as a measure of the change in the purchasingpower of the unit of account, partly because of availability and stability in theestimates. Over a period, the RPI does not usually diverge greatly from othermeasures of general inflation, though for particular classes of shareholderother measures of purchasing power trends may be more relevant. In thewater industry, the RPI is already built into the price control formula as ameasure of general inflation, and this reinforces the relevance of using thisindex in measuring real financial performance.

1.6.2 Normally, to identify the real gains to shareholders, it will be sufficient toestimate the change in nominal value to the business of all assets andliabilities allowing for distributions etc. such as dividends, and make a singleadjustment for the impact of inflation on shareholders' opening funds. Asfurther discussed in paragraph 1.13 below, for regulatory purposes the focusof interest is on the real return on net operating assets, whether these werefinanced by debt or by equity. This requires the separate identification of afinancing adjustment; this is broadly the real gain which shareholders makefrom the impact of inflation on nominal debt liabilities.


1.7 Asset valuation principles

1.7.1 FRS15 – tangible fixed assets sets out the principles of accounting for theinitial measurement, valuation and depreciation of tangible fixed assets. Theprinciples for initial measurement and depreciation set out in FRS15 shouldbe applied to the CC accounts, except where specifically dis-applied forinfrastructure assets (paragraph 1.4.3). In respect of valuation the principlesset out below should be applied to the CC accounts.

1.7.2 In passing all real changes in asset values through the profit and lossaccount, the definition of profits under FCM places stress on appropriatemethods of asset valuation. In an ongoing business, the most relevant basisof valuation is current value to the business. Using the net recoverable valueof assets (from immediate, if orderly, sale) can lead to instability in the timingof recognition of profits especially where specialised assets are significant, asin the water industry. Economic valuation (NPV of gross profit flow) is bothtoo subjective and clearly circular in reasoning in an environment in whichprices are being regulated.

1.7.3 The CCA value of tangible assets to a business means what potentialcompetitors would find it worth paying for them in the absence of barriers toentry and exit from the business, even if the competition is hypothetical. Thiswill be the cost of an asset of equivalent productive capability to satisfy theremaining service potential of the asset being valued - a Modern EquivalentAsset (‘MEA') - if the asset would be worth replacing, or the recoverableamount if it would not.

1.7.4 The gross MEA value is what it would cost to replace an old asset with atechnically up to date new asset with the same service capability allowing forany difference both in the quality of output and in operating costs . The netMEA value is the depreciated value taking into account the remaining servicepotential of an old asset compared with a new asset, and is stated gross ofthird party contributions.

1.7.5 The CCA value of assets to a regulated business may however be affected bythe nature of the regulation. In the water industry the requirement thatregulation should allow for the financial viability of an efficient operator meansthat new investment can be valued on normal CCA principles ignoringpotential restrictions imposed by the regulator. However the constraints onprice levels means that the true value to the business of initial assets isactually the recoverable amount. This would normally be the present value ofthe associated cash flows, discounted at the cost of capital, i.e. the economicvalue. However the estimation of the future cash flows is subjective and couldbe circular since the regulator sets price limits.

1.7.6 Accordingly, in valuing initial operational assets used in the appointedbusiness, existing at the time of privatisation, it is assumed that the effect ofregulatory constraints can be disregarded. The value to the business undersuch circumstances will generally be the MEA. Furthermore initial assets areto be valued at their full MEA, whether or not they were originally, or wouldnow be, paid for by third parties. These modifications to pure real termsaccounting principles are discussed further in paragraph 1.13.


1.8 Valuing new investment

1.8.6 Although the principles of CC asset valuation described above were set out inSSAP 16 and the ASC Handbook, these guidelines generally require the useof the RPI in restating net asset values (and hence the CC depreciationadjustment) rather than the use of specific indices as illustrated in the Notesto SSAP 16 and the Handbook. The rationale for this goes beyond thesimplicity of the adjustment and can most easily be seen in relation to newinvestment, by considering the appropriate treatment of general inflation,expected relative price movements and unexpected relative price movementsseparately.

General inflation

1.8.6 If there is no general inflation and no relative price movements, HC accountswill correctly measure FCM profits. The timing of the recognition of the realprofits will be affected by judgement on depreciation profiles due to physicalwear, rising maintenance costs etc., but over the life of an asset the totaloriginal (real) cost of a new asset will be recognised as an expense.

1.8.6 The correct FCM method of dealing with general inflation (changes in thevalue of the unit of account) is Constant Purchasing Power (‘CPP’) RetailPrice Indexation (RPI) of historical costs.

Expected relative price movement

1.8.6 If, in the absence of general inflation, there is expected to be a relativemovement in the price of an asset, this should in principle be reflected, evenin HCA, in the shape of the depreciation profile and the judgement of assetlives. In particular, where rapid technical progress is expected, it may beappropriate to use some form of accelerated depreciation (sum of digits,reducing balance etc). In aggregating depreciation over assets of differentages, however, sophistication in depreciation profiling may not produce amaterial improvement in the timing of the recognition of profits.

1.8.6 If general inflation is superimposed on the expected relative price movementin asset values, again CPP indexation of the HC accounts is the relevantextra adjustment. In these guidelines it is assumed that HC (and thereforeCC) depreciation profiles adequately reflect judgements about expectedrelative price movements and other relevant factors determining depreciation.

Unexpected relative price movement

1.8.6 In the absence of inflation, conventional HC accounting deals with the effectof unexpected relative price movements on asset values by periodic reviewsof asset lives and in principle, depreciation profiles (as required underFRS15). The relative ‘price’ of the net value of an old asset does notnecessarily move pro rata with the price of a new MEA, for example, if theunexpected price movement leads to a revision of the depreciation profile.The change in the net book value is put through the profit and loss accountand generally smoothed over remaining asset lives.


1.8.7 For revalulation losses other than those caused by a clear consumption ofeconomic benefits FRS15 permits recognition in the statement of totalrecognised gains and losses (STRGL). As the regulatory accounts do notinclude a STRGL all such revaluation losses should be recognised in theprofit and loss account. Similarly under FRS15 revaluation gains aregenerally recognised in the STRGL. In the CC accounts revaluation gainsresulting from unexpected relative price movements should be recognised inthe profit and loss account.

These are the principles, expressed in real terms to deal with general inflationwhich are required to deal with unexpected relative price movements in theseguidelines.

1.8.8 The CC methodology for estimating net asset values is illustrated in theGuidance Notes to SSAP 16 and the Handbook. This is derived fromattempts to measure profit after operating capability maintenance, and doesnot distinguish between expected and unexpected price movements in theuse of specific indices. One consequence is that if all the real change in netassets values so estimated is immediately put to the profit and loss account,the estimate of real profit can be unstable. Although this only affects thetiming of the recognition of real profit, this is a significant reason why theseguidelines require the use of RPI in annual asset revaluation, focusingspecific price changes on the periodic reviews at which the latest AssetManagement Plan ('AMP') information can be taken into account. At thesereviews special consideration can be given to how far net book values needchanging (i.e. in theory, depreciation profiles changed) and the appropriatetreatment in the regulatory accounts.

1.8.9 FRS15 allows, but does not require, entities to carry their fixed assets atrevalued amounts. If the valuation route is chosen it should be appliedconsistently to all fixed assets of the same class. The revaluations need to beregularly updated. This means full valuation at least once every five yearswith a less detailed interim valuation in the third year and in other years ifthere is evidence that the value has changed significantly or, valuations canbe carried out on a rolling basis over a five-year cycle with an interimvaluation on the remaining assets in the class where there has beenindication of a material change in value.

1.8.10 For the purposes of the regulatory accounts, the asset revaluation using RPIshould be carried out on an annual basis. Revaluations arising from specificprice changes should be carried out once every five years to coincide with theproduction of the AMP. In order to ensure consistency across the industrycompanies will be notified in advance by RD letter which year of eachquinquennium this revaluation should be incorporated into the regulatoryaccounts.

Non depreciating assets

1.8.11 To be consistent with the above treatment of depreciating assets, nondepreciating (and possible appreciating) assets should be valued at value tothe business (generally market values ) and real increases taken to income.The initial valuation should be indexed for general inflation using the RPI,unless further revaluation is incorporated in the HC accounts. The guideline


follows the normal HC practice of only recognising, in the profit and lossaccount, holding gains on realisation when they may need to be identified asexceptional or extraordinary.

Goodwill

1.8.12 It is assumed that no implicit goodwill is created by the regulatory process,except that arising from differential efficiency so that changes in the real valueof tangible and monetary assets in the balance sheet are a suitable measureof financial performance. FRS10 – Goodwill and Intangible Assets only allowspurchased goodwill to be capitalised in the balance sheet. Therefore,internally generated goodwill should not be capitalised. Purchased goodwill isthe difference between the cost of the acquired entity and the aggregate ofthe fair values of that entity’s identifiable assets and liabilities. It is assumedthat there will be no goodwill in the appointed business as the parentcompany usually acquires new companies and takes any purchased goodwillto its balance sheet.

1.9 Assets existing at 31 March 1990

1.9.1 The above discussion sets out the principles to be followed in valuing newinvestment. The value of existing assets has been a major factor in thebalance sheets of the water industry for many years. In applying the samevaluation principles to old depreciable assets as to new, the initial estimatesof net asset value clearly accumulate at one time. Where there are revisionsto depreciation profiles, these would have been spread over a long period ifreal terms accounts had been kept from the start of the business.Furthermore, especially in the absence of full historical cost records, the initialnet values will be derived from gross MEA estimates rather than beingdepreciated real historical cost.

1.9.2 The AMPs prepared for price setting purposes are the obvious basis for thenew gross MEA estimates. The general assumption (see paragraph 1.10.6) isthat in the longer term there will be no significant relative movement betweenthe PPI (Producer Price Index) and the RPI. Accordingly it is assumed that abetter estimate of the net replacement cost of initial assets will be obtained byindexing the original September 1987 AMP unit costs to 31 March 1990 usingthe RPI rather than the PPI leaving depreciation profiles unadjusted.

1.9.3 It has already been explained in paragraph 1.7.6 above that the valuation ofinitial operational assets is to disregard the impact of the regulatory regimewhich would otherwise imply that the value to the business was therecoverable amount. Surplus land however is to be treated as an investmentfor this purpose as its value to the business taking into account any proceedsthat are passed on to customers. Initial assets are defined to be those inplace at the beginning of the first accounting period under the present regime,i.e. March 31, 1990.

1.9.4 Returning below to the special case of infrastructure assets, the initial valuesof the bulk of above ground assets were based upon the net values as atSeptember 1987 using (SSAP 16 Guidance Notes) CCA methodology,incorporating specific price movements to that date. These were adjustedwhere appropriate for AMP information and indexed using the RPI to 31


March 1990. From 31 March 1990, the guidelines require the use of RPIindexation with subsequent reviews of relative price trends, as for newinvestment above. At periodic reviews, it will be important to identify howmuch of the change in real values represents further improvements in theinitial value estimate, to be treated as a prior year adjustment, and how muchshould be taken through the profit and loss account.

1.9.5 The MEAs of the existing system in use, estimated on a plant by plant basismay seem an overestimate in that, starting from scratch, the system wouldprobably be designed quite differently for example, with fewer, larger plant.However, except where there is a clear definition to redesign and rebuild thesystem in 'optimum' configuration, the MEAs should be based on the actualsystem. The MEAs of individual components, where necessary, shouldnevertheless be based on expected capacity in use. As systems expand andchange, a degree of suboptimality at any one time is inevitable and part of thetotal cost of output. If rebuilding is introduced in future AMPs, care will have tobe taken over the treatment of the NBV of redundant assets; again asignificant part may be refinement of the initial valuation rather than costincurred in the subsequent period.

1.9.6 In principle net MEAs of existing assets should be adjusted or the differentoperating costs of the actual assets compared with their modern equivalent. Itis assumed that this has been done, for example, by deducting the presentvalue of the difference in operating costs from the unadjusted MEA values.

1.10 Infrastructure assets

1.10.1 The valuation of existing assets in the water industry is, of course, heavilyinfluenced by the value of infrastructure assets. The indefinite life of theseassets has led to the adoption of infrastructure renewals accounting, in whichthe measure of the consumption of capital is based on the expected actuallevel of renewals expenditure. Given that most infrastructure assets are worthreplacing, even if replacement is not a foreseeable eventuality, the adoptionof infrastructure renewals accounting has led to a reconsideration of theprinciples to be adopted in identifying the value to the business of existinginfrastructure assets. FRS15 does not allow renewals accounting asmentioned previously in paragraph 1.4.3 and therefore that part of the FRSshould be disapplied for regulatory accounting purposes.

Gross MEAs

1.10.2 The gross MEAs of infrastructure assets should usually be based on thereplacement cost of assets delivering to modern standards, defined as thestandards upon which initial AMPs were based.

Abatement factors

1.10.3 Up to March 1992 when this RAG was first issued, the water and seweragecompanies (WaSCs) applied a 40% abatement factor to the pre 1981 MEAvalues of mains and sewers. Conventional depreciation was calculated on thebasis of the abated assets value. Historically, this abatement factor wasaimed at addressing such issues as redundancy and the extent to which


existing assets would not have to be replaced at the expense of the company,partly due to technical progress in relining techniques.

1.10.4 The Guidelines require that no abatement factor is applied and any formeraccumulated current cost depreciation charge is not to be deducted. The newgross value is then to be indexed only by the RPI between periodic reviews atwhich new AMP information will be taken into account. The rationale for thisand the implicit simplifications are discussed below.

Redundancy

1.10.5 Although redundancy was one of the factors lying behind the 40% abatementfactor, it is assumed that redundant assets have now been appropriatelyreflected in the length, diameter etc. of MEAs. As noted above in paragraph1.9.4, it is the existing system in use which is to be valued including theexisting suboptimality of layout. It is assumed that writing off furtherredundancies as they are recognised will not so materially distort profitrecognition that a depreciation provision for accruing redundancy in thesystem will be required.

Technical progress

1.10.6 ‘Technical progress' is used here as shorthand for relative price movementsaffecting the value to the business of infrastructure assets. Some prices forexample, of labour, will almost certainly rise in real terms but it is assumedthat technical progress affecting infrastructure assets is not so rapid thatoverall, replacement costs fall in real terms. Accordingly, no furtherdepreciation obsolescence is required from present gross MEAs

1.10.7 In the past, one aspect of technical progress has been the development of 'no- dig' relining techniques. In extremes, this could mean that all renewalsexpenditure relates to relining the 'pipe' and the 'hole' does not depreciate atall. Accordingly, like land, the 'hole' element would retain its original real costvalue to the business although in the absence of this historical costinformation, initial MEA costs of hole (and pipe) are to be used instead andindexed for RPI.

Third party contributions

1.10.8 In assessing the opening value of assets at 31 March 1990 in the regulatoryaccounts, the extent of third party financing affects the worth to the business.Ofwat has concluded that, for the purposes to which the CC accounts of theindustry will be put, the amount of the deduction for third party contributionson initial assets is essentially arbitrary; any deduction will lead to anautomatic adjustment of the initial rate of return being earned on theseassets. A revision in the initial deduction will be offset by a revision in the rateof return which will be ignored for the purposes of monitoring the trends inreal profit rates. For the purpose of monitoring the real cost efficiency it is inany case the cost gross of third party contributions which are most relevant.

1.10.9 Accordingly it is assumed that assets in place at March 31, 1990 would nothave been subject to third party contributions and so the guidelines requirethat no deduction be made for third party finance. Any deductions made in


existing CCA gross asset values for example, on post 1981 assets, should beremoved notably by using unit replacement costs from AMPs. Future (actual)third party contributions are to be treated like grants and carried forward (inreal terms) as deferred income deducted in net operating assets.Consequently for example, adopted assets are to be brought in as an asset inthe year of adoption at their MEA cost with a corresponding credit to thirdparty contributions.

1.10.10 Future government grants on infrastructure assets are assumed to benegligible. No deduction from existing infrastructure assets to allow for thisform of finance is therefore required. If such grants occur in future they will betreated as windfalls reducing the cost of particular assets. However tomaintain consistency with the treatment of grants on other assets, they are tobe shown separately as deferred income deducted in calculating netoperating assets. Unlike the equivalent grants for non - infrastructure assets,this deferred income is not written (in real terms) to the profit and lossaccount over time. This is consistent with the assumption above of nodepreciation on infrastructure assets. The accrued grants are only indexed bythe RPI.

1.11 Current cost profit and loss account

1.11.1 In reconciling the HC and CC profit and loss accounts, it is convenient toadopt the notation that:

RPI= % change in RPI in financial year = Closing RPI - Opening RPI Opening RPI

1.11.2 It follows from the definition of real FCM profit in paragraph 1.5 that:

Real FCM retained profit = increase in reserves less RPI x openingshareholders funds.

where:

increase in reserves = HC retained profit + nominal gains on assets notrecognised in HC profit less nominal gains recognised in HC profit in thisperiod not previously so recognised (for example, on disposals).

and

RPI x opening shareholders funds = RPI x opening fixed assets plus RPI xopening working capital less RPI x opening net finance, where fixed assetsare net of third party contributions.

Fixed asset adjustments

1.11.3 With the above assumptions and simplifications, the fixed asset adjustmentscan be derived as follows:

Nominal gains not recognised in HC profit


- nominal gains recognised in HC profit in the period not previouslyso recognised

- RPI x opening fixed assets

= (closing CC fixed assets less opening CC fixed assets) lessclosing HC fixed assets less opening HC fixed assets) less RPI xopening CC fixed assets.

= (opening CC NBV + RPI x opening CC NBV + AMP adjustment +additions less CC NBV of disposals less CC depreciation lessopening CC NBV) less (opening HC NBV + additions less HC NBVof disposals less HC depreciation less opening HC NBV) less RPIx opening CC NBV.

= AMP adjustment less(CC depreciation less HC depreciation) less(CC NBV of disposals less HC NBV of disposals).

1.11.4 In the absence of an AMP adjustment, this equals the depreciationadjustment plus the disposal of fixed asset adjustment described inparagraph 3.3.1. If real unrealised gains or losses have been taken to thecurrent cost reserve then a more sophisticated disposal of fixed assetsadjustment will be needed. Adjustments to asset values arising from futureAMP revisions will only be taken into account at the time of periodic pricereviews. A distinction is then likely to have to be drawn between revision tothe value of existing assets at the time of the introduction of the newregulatory regime and that of assets subsequently introduced. It will also benecessary to ensure consistency with assumptions and revisions ondepreciation charges and renewals charges.

1.11.5 It has also been assumed for fixed assets that RPI indexation is immaterial, inother words all additions occur at the year end; and assets in use with an HCnet book value of zero have been valued at net MEA value.

Working capital adjustment

1.11.6 The working capital adjustment is the adjustment for the impact of generalinflation on the real value of the working capital of the business.

1.11.7 RPI x opening working capital in paragraph 1.11.2 equals the working capitaladjustment in paragraph 3.3.1. The need to identify a working capitaladjustment separately in measuring real term profits is a by product of theneed to identify the financing adjustment as discussed in paragraph 1.6.2.Theoretically, whether or not an asset or liability should be included in theworking capital or financing adjustments depends on whether thecorresponding, nominal income stream is (implicitly or explicitly) above orbelow operating profit. For example, if any cash balances are treated as partof working capital, the income on those balances would have to be includedin operating profit. However in these guidelines, it has been assumed forworking capital that:

- all cash can be included with net finance rather than being split betweenworking capital and net finance; and


- holding gains on stock during the year are immaterial. In other words, theCC valuation of closing stock equals the HC valuation of closing stock.

Financing adjustment

1.11.8 The financing adjustment is the real gain or loss arising for shareholders fromthe impact of general inflation on monetary assets and liabilities.

1.11.9 RPI x opening net finance in paragraph 1.11.2 equals the financingadjustment in paragraph 3.3.3. It has been assumed for net finance that :

- the CC valuation of closing investments equals the HCvaluation of closing investments;

- the CC capitalisation of interest during construction equals theHC capitalisation of interest during construction in real terms; and

- the impact of changes in interest rates on the value to the business offinancing liabilities can be ignored. Since this would only affect thedivision of profits between shareholders and debt holders, it is not amatter of immediate significance for regulatory purposes anyway.

1.11.10 The financing adjustment should be refined if equity is issued during the yearfor cash as follows:

Financing adjustment = opening net finance x RPI less equity injection x RPIafter injection;

where RPI after injection denotes the percentage increase in the RPIbetween the date of the equity injection and the date of the closing balancesheet. This refinement is itself an approximation and can be explained asfollows.

1.11.11 If equity is issued during the year, it is assumed that most of this equity will bein the form of cash at the year end and will not have been converted into fixedassets. This cash will earn interest at nominal interest rates and it is thereforeappropriate to reduce the financing adjustment which is concerned in partwith converting nominal interest to real interest.

1.11.12 If instead, loans have been raised during the year, it is again assumed thatmost of these loans will not have been converted into fixed assets at the yearend. However, in this instance, the loans will be automatically offset againstthe associated cash because of the definition of net finance and so no explicitrefinement of the financing adjustment is required.

Infrastructure renewals charge (IRC)

1.11.13 This appears in both the regulatory HC and CC profit and loss accounts but isno longer included in the HC statutory accounts. The basis of theinfrastructure renewals charge has to be conceptually consistent with theabove assumptions on asset valuation. For accounting purposes the IRCshould reflect the company’s assessment of its long-term capital maintenance


needs for its infrastructure assets. As a measure of capital consumption, itcontains no provisions for redundancy or obsolescence, or allowance forrenewals holidays on new investment.

1.11.14 To maintain this element of consistency with the assumptions on assetvaluation, with effect from the 1991 - 92 regulatory accounts, it has beenappropriate to index the renewals charge by RPI, as measured by theaverage inflation rate over the year. (Previous to this, although the guidelinesadvocated the use of COPI rather than RPI different companies wereapplying different indices in the calculation of the infrastructure renewalscharge). This basis of calculation applies in the first instance, to the currentcost accounts but companies should use the same basis for their regulatoryhistorical cost accounts.

1.11.15 The infrastructure renewals accrual or prepayment is included in workingcapital in the balance sheet. The renewals accrual may indicate that thecompany will need to carry out higher levels of maintenance sometime in thefuture for which it has already been remunerated. The renewals prepaymentindicates that the company is ahead of the original plan and there will be alikelihood of lower levels of maintenance in the short term. The opening valueis to be indexed by the RPI in the CC balance sheet in line with the revisedtreatment of the infrastructure renewals charge above, with the real increasecharged to the profit and loss account. In HCA regulatory accounts all thenominal increase is charged to the profit and loss account. The effect ofincluding the renewals accrual in the working capital adjustment is to reversethe RPI element already included in historical cost operating profit leavingonly the real element in current cost operating profit.

1.12 Regulatory capital values

1.12.1 As discussed in paragraph 1.9.3, the valuation of initial operating assetsshould disregard the impact of the regulatory regime which would otherwiseimply that the value to the business was the recoverable amount. To dateMEA values have been reflected in the regulatory accounts with no referenceto or inclusion of the value placed on the asset base for regulatory purposes(primarily for price setting). However, over time analysts and investors haveincreased their focus on the RCV, using it as a proxy for market values.Therefore from the 2002-03 financial year onward the regulatory capital valuewill be included in a note to the regulatory accounts. This will enable readersof the accounts to assess the value of the assets used for regulatorypurposes (the RCV) relative to the largely replacement value of the assets(the MEA value).

1.12.2 The RCV starts with a direct measure of the value placed on each company’scapital and debt by the financial markets following privatisation (or a broadlysimilar measure for water only companies which were not floated). This isthen rolled forward to take account of new capital investment, net ofdepreciation. The calculation of RCVs is an essential element in Ofwat’s pricedetermination process. They also act as a proxy for market values and assuch form an important basis for measuring financial performance.


1.12.3 The Ofwat methodology is effectively a regulatory hybrid to provide equitabletreatment between consumers and shareholders. It is based on acquisitioncosts to ensure that there is no windfall gain to shareholders. Consumersincur depreciation charges based on current replacement (MEA) costs, sothat each period consumers pay for the asset value used in the servicessupplied.

1.12.4 The initial RCV is calculated as the average of the market value of each waterand sewerage company for the first 200 days for which the shares were listedplus the total value of debt at privatisation. A proxy for the initial market valuewas used for the water only companies that were not privatised in 1989.

1.12.5 The value has been adjusted each year to take account of net investment.Capital expenditure to enhance and maintain the network which has beenassumed in setting price limits has been added to the value. This is afterdeducting the amount of depreciation (based on the MEA values of theassets) which has been assumed in setting price limits. Any grants andcontributions and associated amortisation are also taken into account.Infrastructure renewals expenditure is not added to the RCV but themovement in the infrastructure renewals accrual or prepayment is included.Adjustments are also made in respect of disposals of land to remove thevalue of this from the RCV.

1.12.6 The RCV is adjusted each year by RPI to take account of inflation.

1.12.7 By setting out clear guidance on RCV methodology and publishing the valuesof the RCV in the regulatory accounts, transparency will be aided and therewill be consistency between the companies. The figures in the reconciliationwill be those determined by Ofwat at Periodic Reviews. The proforma for theRCV is illustrated in RAG3.05, appendix 2 and also in section 3.5 of thisguideline.

Logging up of capital expenditure

1.12.8 The net additional capital expenditure included in the RCV at periodic reviewsis the amount determined by Ofwat as necessary for companies to meet newobligations, improve service levels and maintain the existing asset base.Between periodic reviews, if the company is required to meet additionalstatutory obligations the capital costs associated with this work are ‘loggedup’ and are added to the RCV at the next review. The level of costassociated with those assets which is incorporated into the RCV is subject tochallenge by Ofwat as it would be at a periodic review.

1.12.9 Any investment over and above the levels projected at price reviews, whichdoes not meet the definition of a new statutory requirement, is not as a matterof course, included in the RCV for future remuneration. Exceptions to thismay be made. For example, for the 1999 periodic review expenditure in totalfor each service for the period 1995-2000 in excess of determination wasincluded where companies provided clear and incontrovertible evidence thatcustomers had been consulted, that the investment was a clear priority forthem and that they were prepared to pay higher bills.


1.12.10 MD145 ‘The framework for setting prices’ (3 March 1999) sets out for the1999 review Ofwat’s approach to investment over and above that delivered atthe 1994 periodic review.

Efficiency

1.12.11 In order to provide incentives to encourage companies to continue to improveefficiency, where companies have spent less in delivering the requiredoutputs than determined at periodic reviews they may keep the benefits ofthese capital efficiencies for a specific period of time, after which they arepassed to customers.

1.12.12 For the 1999 periodic review a 5 rolling year period was adopted. Forexample, if in 1994-95 a company actually incurred capital expenditure of£80m compared to £100m assumed by Ofwat, the company would continueto be remunerated for £100m in the RCV for the five-years until 2000-01when the RCV would be adjusted downward by £20m. The reconciliation ofthe opening and closing RCV to be included in the accounts is discussed insection 3.5.

1.13 Limitations on use

1.13.1 This section identifies various limits which can be placed on the interpretationand uses of the CC accounts in the water industry for regulatory purposes,given the assumptions and simplifications set out above.

1.13.2 Historically, the most important assumption was that the effect of theregulatory regime on the value to the business of initial assets could beignored. This amounted to avoiding the adoption of acquisition accounting,with premature judgement about economic values including the relevant costof capital. The MEA values to be used also assumed that there would havebeen no third party contributions on initial assets which would have beentaken into account in an economic value. These assumptions represent theprinciple modification to real terms accounting required by these guidelines.

1.13.3 Given the adoption of MEA initial values, rather than real acquisition costs,the initial absolute level of rate of return on CC capital employed would beabnormally low. Furthermore, the differences in this rate between companieswill be an accident of history reflecting where each company happens to havereached in the process of determining prices in the previous regulatoryregimes, whether statutory or in the nationalised industry control framework.There is no implication from the existing regulatory framework that the rate ofreturn on initial assets should be either equalised or brought up to normalprofit rates overall in the near future.

1.13.4 An alternative approach to asset valuation would have been to value initialassets at the market value when the regulatory regime was introduced. In thecase of the WaSCs this could have been identified with the market value onflotation which, allowing for debt, represents the acquisition cost for the newshareholders. For the water only companies (WoCs), the capital market valueon conversion to the new regulatory regime would have been relevant.However there are significant areas of judgement which would have beennecessary in determining the precise timing of the relevant market valuation if


it was both to avoid excluding legitimate flotation discount costs and to avoidcircularity in anticipating the effects of profit regulation on the economic valueof assets. Although valuation of assets on this basis, in aggregate, wouldhave allowed profit rates to be nearer to normal levels, it was considered thatthe subjective judgements involved were more appropriately confined to theallowed rate of change in the low rates of return than frozen in initial assetvalues. Furthermore the total current costs, including the cost of capital, ofdifferent services would have been meaningless for comparative purposesusing this alternative valuation method. Although MEA valuation is the mostappropriate method of asset valuation for the purposes of the regulatoryaccounts, the RCV is an essential element in Ofwat’s price determinationprocess and is used widely by the investment community. It is now includedin the regulatory accounts as a separate note.

1.13.5 Nevertheless there are considerable uncertainties identified above in theMEA valuation of initial assets, particularly the third party financingassumption and the extent of initial depreciation. The principles adopted aredesigned to monitor correctly the return being earned on new investment insatisfaction of the obligation to ensure financial viability. Adjustments to thevalue of initial assets from subsequent AMP reviews, and the effect on overallrates of return, will largely be discounted for regulatory purposes. Forcomparing cost efficiency, the costs without any deduction for third partyfinance also seem more relevant.

1.13.6 In conclusion the form of current cost accounts required by the Licence will beused for the purposes of monitoring:

- the trend in real rates of return between companies;- the comparative cost levels of different services between companies

including the cost of capital on the capital employed.

The trend in profit rates will need to be monitored to allow for a reasonablereturn on new investment. The analysis of the real cost levels of differentservices will contribute to the required judgements about efficiency levels.The inclusion of the RCV’s in the regulatory accounts will ensure consistencyof approach by the companies and also aid transparency for our stakeholderswith regard to the publishing of future RCVs.


Part Two – Definition of terms

AMP adjustment The revision in the real value arisingperiodically from improved information notablyin the AMPs

Current cost operatingprofit

Calculated on a real terms basis at the pretax, pre interest level.

Financing adjustment The impact of general inflation on the realvalue of net finance for the business.

Infrastructure assets Mainly underground systems of mains andsewers, impounding and pumped raw storagereservoirs, dams, sludge pipelines and seaoutfalls. Information about infrastructure assetsis also to be regarded as an infrastructureasset.

Infrastructure charge The initial charge for connecting premises tothe water and sewerage system for domesticpurposes as defined in Section 79(2) of the1989 Water Act.

Infrastructure renewalsaccrual/prepayment

The provision for the accumulated shortfall(overshoot) between actual renewalsexpenditure and the infrastructure renewalscharge.

Infrastructure renewalscharge

The annual accounting provision forexpenditure on the renewal of infrastructureassets charged to the profit and loss account.It should reflect the company’s assessment ofits long-term infrastructure renewalsexpenditure needs.

Initial assets Those in place at March 31, 1990.

Modified real termsaccounting

Real terms accounting modified by theexclusion of unrealised gains and the inclusionof initial operational assets at their value to thebusiness ignoring the impact of the regulatoryregime and the extent of third partycontributions.

Net finance All monetary assets and liabilities other than toequity shareholders, which are not included inworking capital. It therefore includesinvestments, including cash held as an


investment, all creditors other than tradecreditors but excludes proposed dividends.

Operational assets Assets including those of a specialised natureemployed for operational purposes, namely:Intake works, pumping stations, treatmentworks, boreholes and operational land. Landwhich is not currently in operational use but isexpected to be in operational use in theforeseeable future should also be included inthis category, as should plant and machineryinherent in the nature of the works. Offices,depots, workshops, residential propertiesdirectly connected with water and sewerageservices and land held for the purpose ofprotecting the wholesomeness of watersupplies.

Other assets Non specialised, non operational plant,machinery, vehicles, surplus land and all otherassets not listed in the categories above.

Real After allowing for the impact of generalinflation on the purchasing power of the unit ofaccount.

Real financial capitalmaintenance

The measurement of profit after allowing formaintaining the real value of shareholders'funds.

Real terms accounting The combination of valuing assets at value tothe business with the inclusion of all realisedand unrealised gains in the measurement ofprofit after real financial capital maintenance.

Recoverable amount The greater of the net realisable value of anasset and where applicable, the amountrecoverable from its further use, discounted asappropriate.

Regulatory capital value The capital base used in setting price limits.The value of the appointed business whichearns a return on investment. It representsthe market value (200 day average), includingdebt, plus subsequent new capital expenditure(net of depreciation) as assumed at the time ofprice setting and including new obligationsimposed since 1989.


Third party contributionssince 1989 – 90

Grants and third party contributions receivedin respect of infrastructure assets and anydeferred income relating to grants and thirdparty contributions for non infrastructureassets.

Value to the business Net current replacement cost or if apermanent diminution below net currentreplacement cost has been recognised,recoverable amount.

Working capital The aggregate of stocks, trade debtors, tradecreditors and working cash balances, ifmaterial. Trade creditors include short -termcreditors for capital goods, the infrastructurerenewals accrual and any creditor balancesrelating to expenditure which is charged to theprofit and loss account before operating profit.

Working capitaladjustment

The adjustment for the impact of generalinflation on the real value of working capital tothe business.


Part Three – Accounting guideline

3.1 Scope

3.1.1 Under Condition F of the Licence, companies are responsible for publishingaudited CCA statements in accordance with these guidelines. CCA statementsare required only for the appointed business of the Appointee.

3.1.2 Under the information requirements of Condition B, companies are also requiredto submit audited HCA and CCA information on a charging year basis for thepurpose of assessing possible interim K adjustments. The procedure forsubmitting this actual data is set out in 'RD/MD’ letters.

3.1.3 These guidelines require that the CCA statements be prepared on the basis ofmodified real terms accounting in accordance with paragraphs 3.2 and 3.3. CCAstatements should contain a profit and loss account and balance sheet togetherwith supplementary notes and information in the form set out in Appendix 2 ofRAG 3.05.

3.1.4 Merger accounting rules will apply for regulatory accounts to ensure reliable andcompatible information to support a regulatory approach which relies uponcomparative competition. Therefore FRS6 (Acquisitions and Mergers) is to bedisapplied for appointed businesses that have been amalgamated to ensure thata full years performance is adequately reflected in the regulatory accounts in theyear of amalgamation.

3.2 Current cost balance sheet

3.2.1 The current cost balance sheet should include all assets, which the appointedbusiness owns or is responsible for operating except for those subject tooperating leases.

3.2.2 Except as indicated below, assets and liabilities should be included on a basisconsistent with the historical cost statements.

3.2.3 Assets originally funded, wholly or partly, by third parties such as adopted,requisitioned and Section 24 assets and communication pipes from mains tostop taps, should be valued as for assets funded by the companies themselves.

3.2.4 Initial assets in operational use should be valued at net current replacementcost.

3.2.5 All other fixed assets including those not in operational use such as surplus land, should be included at their value to the business.

3.2.6 Assets under construction should be included in the appropriate asset category.Any interest capitalised in the HC accounts should also be capitalised in the CCaccounts but using the equivalent real rate of return calculated by adjustment forthe RPI.


Infrastructure assets

3.2.7 Infrastructure assets should be valued at their gross current replacement cost,calculated as follows, without being subject to depreciation.

Gross replacement costOpening balanceAMP adjustmentRPI adjustmentDisposalsAdditionsClosing balance

Each line in this calculation is discussed below.

Opening balance

3.2.8 Opening balances will be the closing balance from the previous financial yearcarried forward.

AMP adjustment

3.2.9 The AMP adjustment is the revaluation adjustment required to bring the assetsto the gross modern equivalent asset value. The increase to the MEA valuearising from adjustments for general inflation through the RPI adjustment shouldbe taken to the current cost reserve. All other increases or decreases should bereflected in the profit and loss account as a result of the consideration of thedepreciation profile and asset lives. The adjustments is calculated at a periodicreview and incorporated into the accounts generally in the first year of thefollowing AMP period. The period in which the adjustment should beincorporated into the accounts will be confirmed in advance by Ofwat in an RDletter.

RPI adjustment

3.2.10 The opening balance after amendment by the AMP adjustment, should berestated using the RPI. The amounts at which asset values are carried willtherefore be frozen in real terms between AMP reviews, subject to subsequentadditions and disposals. In this RPI adjustment, RPI denotes the percentagechange in the retail price index between the opening and closing balance sheetdates. This will be based on the RPI published in April and notified to companiesby Ofwat immediately after its publication. RPI indexation on additions duringthe year may be assumed to be immaterial.

Disposals

3.2.11 In the event of the disposal of infrastructure assets, the opening balance shouldbe reduced by the gross value of the disposed assets.


Additions

3.2.12 Additions to the opening balance comprise expenditure on enhancement andasset maintenance of the base service of the asset base.

3.2.13 Additions should be stated gross of third party contributions such as grants andinfrastructure charges.

Operational assets

3.2.14 All operational assets including specialised and non-specialised operationalproperties should be valued in the current cost balance sheet at their net currentreplacement cost which is calculated as follows.

Gross replacement cost

Opening balanceAMP adjustmentRPI adjustmentDisposalsAdditionsClosing balance

Accumulated depreciation

Opening balanceAMP adjustmentRPI adjustmentDisposalsProvision for yearClosing balance

Net Book Value

Closing balance

Opening balance

Each line in this calculation is discussed below.

Opening balance

3.2.15 The opening balances will be the closing balances from the previous financialyear carried forward.

AMP adjustment

3.2.16 The AMP adjustment is the revaluation adjustment required to bring the assetsto the gross modern equivalent asset value.


RPI adjustment

3.2.17 The opening balance for gross replacement cost and accumulated depreciationafter amendment by the AMP adjustment, should be restated using the RPI. Theindexation of additions during the year may be assumed to be immaterial.

Disposals

3.2.18 Asset disposals should be written off gross replacement cost and accumulateddepreciation.

Additions

3.2.19 Fixed asset additions should be stated gross of third party contributions such asgrants and infrastructure charges.

Provision for year

3.2.20 The depreciation charge for the year should be calculated using the samedepreciation profiles and asset lives as for the historical cost depreciationcharge. In principle the depreciation profiles should take account of technicalprogress, the cost of capital, variations in output and changing running costs.

Non specialised operational properties

3.2.21 Non specialised operational properties should be valued at estimated openmarket value on an existing use basis using the proforma set out above forspecialised operational assets. The calculation of each line in this proforma is asdescribed above. The estimates of open market value should generally berestated using the RPI between periodic reviews but revaluations in historicalcost accounts should be incorporated in the current cost accounts with changesin real value identified separately in the current cost reserve.

Other tangible assets

3.2.22 Other tangible assets include non specialised plant, machinery, vehicles,surplus land and all other assets not included in the categories listed above.

3.2.23These assets, with the exception of surplus land, should be valued at estimatednet current replacement cost using the proforma in paragraph 3.2.14.

3.2.24Surplus land should be valued at value to the business taking into account anyproceeds that are to be passed to customers.

Third party contributions since 31 March 1990

3.2.25Third party contributions received in 1990 - 91 and thereafter should be treatedin the balance sheet as deferred income, indexed using RPI and credited to theprofit and loss account in line with the depreciation charge on the assetsfinanced. Accordingly contributions in respect of infrastructure assets shouldsimply be accumulated in real terms subject to disposals.


Reserves

3.2.26 Reserves in the current cost balance sheet should include revaluation surplusesor deficits and adjustments made to allow for the impact of price changes inarriving at current cost profit attributable to shareholders.

3.3 Current cost profit and loss account

Adjustments to historical cost operating profit

3.3.1 The current cost operating profit should be derived from the historical costoperating profit by deduction of the following adjustments:

- in relation to fixed assets, a depreciation adjustment equal tocurrent cost depreciation less historical cost depreciation;

- in relation to the disposal of fixed assets, a disposal of fixedassets adjustment equal to the current cost net book value of disposedassets less the historical cost net book value of disposed assets; and

- in relation to working capital, a working capital adjustment.

The recommended proformas for the submission of the regulatory accounts areset out in RAG 3.05 and include an analysis of the current cost operating profitwhich contains the current cost depreciation charge and the current cost profiton the disposal of fixed assets rather than making the relevant adjustments tothe historical cost operating profit.

3.3.2 The calculation of current cost depreciation on non-infrastructure assets isdescribed in paragraph 3.2.21. No depreciation is charged on infrastructureassets in the regulatory accounting statements and there is therefore no currentcost depreciation charge for infrastructure assets, FRS12 and FRS15 are to bedis-applied for infrastructure assets for the purposes of the regulatory accounts.


3.3.3 The calculation of current cost profit attributable to shareholders before taxationneeds to take account of real gains arising from the effect of inflation on netfinance. The relevant adjustment is called a financing adjustment. Normally thisshould be calculated as opening net finance multiplied by the percentagechange in the RPI during the financial year.

3.3.4 The calculation may require modification if new finance is raised during the year.In particular, if equity is issued during the year for cash then this adjustmentshould normally be reduced by the impact of general inflation as measured bythe percentage change in the RPI between the date of the equity injection andthe date of the closing balance sheet, on the real value of the equity issued. Anymore refined basis of adjustment for changes in net finance during the yearshould be disclosed.

Exceptional items

3.3.6 Exceptional items should be disclosed as a separate item. An analysis of thetype and amount of each item should be added to the notes.


Extraordinary items

3.3.6 .FRS3 Reporting Financial Performance states that extraordinary items areextremely rare as they relate to highly abnormal events or transactions that falloutside the ordinary activities of a reporting entity and which are not expected torecur. If extraordinary items do occur, the should be positioned on the P&L afterprofit on ordinary activities after tax and minority interests.

3.4 Contents of accounts

3.4.1 Proformas for the current cost regulatory accounting information are containedin Appendix 2 of RAG 3.05. These proformas comprise:

- current cost profit and loss account;- current cost balance sheet;- cash flow statement; - analysis of turnover and operating income;- current cost analysis of fixed assets by asset type and service;- current cost working capital;- movement on current cost reserve;- reconciliation of current cost operating profit to net cash flow from

operating activities;- regulatory capital value;- 5 year rolling summary – profit and loss;- 5 year rolling summary – balance sheet;- disaggregated activities.

3.4.2 All the tables (with the exception of regulatory capital value) should disclosecurrent year's figures alongside the previous year's figures.

3.4.3 The bases used for the allocation of general assets between water, sewerage

and sewage treatment and disposal should be disclosed as required byparagraph 7 of Condition F.

3.4.4 A further note to the CCA statements should analyse current cost net bookvalue only by service and by asset type simultaneously.

3.4.5 The RCV should be disclosed in a separate note. This should reflect the valuedetermined by Ofwat for price setting purposes and show the roll forward fromthe value of the start of the period to the closing value at the end of the period.The requirements for disclosure of the RCV are discussed further in Section 3.5below.

3.4.6 A rolling five year summary of the current cost profit and loss account andbalance sheet should be included as a note to the CCA statements. All figuresin this five year summary should be restated into pounds of the final year usingRPI indexation.

3.5 Regulatory capital value (RCV)

3.5.1 The RCV reconciliation should be in current year prices and reflect the rollingbasis adopted as a result of the consultation paper MD172 ‘Publishing future


regulatory capital values’ (13 September 2001). The amounts to be included inthe regulatory accounts are those determined by Ofwat at periodic reviews. Thisis the amount on which companies earn a rate of return.

3.5.2 CurrentYear

PriorYear

1. Opening RCV x2. Capital expenditure x3. Infrastructure renewals expenditure x4. Grants and contributions (x)5. Depreciation (x)6. Infrastructure renewals charge (x)7. Outperformance of Regulatory

Assumptions (5 years in arrears)(x)

Closing RCV xAverage year RCV x

All amounts are in current year prices. As the RCV and the amounts to beincluded are those determined by Ofwat, companies should contact Ofwat inadvance of publication to confirm the figures which should be reported. Contactdetails will be provided each year in the RD letter which Ofwat issues confirmingrequirements for the regulatory accounts.

Opening RCV

3.5.2 This is the closing value from the previous year inflated using RPI to the currentyear price base.

All the amounts are those projected by Ofwat at the last periodic review.

Capital expenditure

3.5.3 In this reconciliation this is projected net capex (net of IRE).

Grants and contributions

3.5.4 These are grants and contributions received in respect of non-infrastructureassets. The figures are deducted from the RCV.

Depreciation

3.5.5 This is current cost depreciation on non-infrastructure assets and is deductedfrom the RCV. The depreciation charge is calculated from the MEA value of theassets. It is the charge assumed by Ofwat in setting price limits.

Infrastructure renewals expenditure

3.5.6 IRE is net planned maintenance expenditure on the infrastructure network, ienet of any grants and contributions. The IRE is taken together with theinfrastructure renewals charge (IRC) to ensure that the movement in theinfrastructure renewals accrual/prepayment is included. This reflects the extent


to which more (or less) money has been spent in maintaining infrastructureasset base thus increasing (or decreasing) the value to be remunerated.

Infrastructure renewals charge

3.5.7 The annual IRC is deducted from the RCV Infrastructure Renewals accountingis used for long–life network assets. It is based on an operational assessment ofactivity needed to maintain the serviceability of the underground infrastructureover an appropriate time horizon. The IRC should reflect the long-termmaintenance needs of the infrastructure assets network.

Outperformance of Regulatory Assumptions (5 years in arrears)

3.5.8 The RCV reflects past capital efficiencies and hence the benefit of these can betransferred to customers through lower prices. In order to maintain incentives,companies retain the benefit of the capital efficiencies for a fixed period beforethey are transferred to customers. For the 1999 Periodic Review this period was5 years.

3.5.9 The capital efficiencies line shows the cumulative value of out-performance. TheRCV is adjusted on a rolling basis to ensure companies retain the efficiencysavings for five years. For example, in 2000-01 the RCV is adjusted forefficiencies made in 1994-95. The adjustment to take account of past capitalefficiencies was introduced for the first time at the 1999 Periodic Review. Thefirst year of the new price limits resulting from this review was 2000-01 and theRCV was adjusted in this year to take account of efficiencies achieved in 1994-95. However, in 2000-01 companies would have already had the benefit ofcapital efficiencies made prior to 1994-95 for more than five years. Anadjustment to the opening RCV for 2000-01 was therefore made for capitalefficiencies made in 1993-94. The period 1990-91 to 1992-93 was consideredin total and where for this period overall efficiencies had been made, anadjustment was made to the opening RCV in 2000-01.

3.5.10 As set out in MD145 – ‘The Framework for Setting Prices’ (8 March 1999)capital expenditure efficiencies are calculated by comparing the projectedvalues of capital expenditure (and the movement in the infrastructure renewalsaccrual or prepayment and actual values). A comparison of projected and actualdepreciation is not made. However, an adjustment to the depreciationattributable to the difference in expenditure has been calculated using astandard asset life for each service. The capital efficiencies are deducted fromthe RCV. Consideration may be given to the overall profile of the efficiencyadjustments with a five year price setting period. If it is judged to be necessary,the profile resulting from the comparison of capital expenditure in each year maybe smoothed.

Closing RCV

3.5.11 This is the sum of lines 1 to 7 paragraph 3.5.1 and is rolled forward each year tobecome the opening RCV for the following year.


Average year RCV

3.5.12 This is the sum of the opening and closing RCV for the year at 1997/98 prices,divided by two, and inflated by the change in financial year average RPI.

3.5.13 Companies will be required to provide an explanation that the note sets out theRCV used in setting price limits for the period 2000-01 to 2004-05. The actualexpenditure level during the year recorded in the regulatory accounts and thatshown in the reconciliation may differ, as may depreciation. Differences in thecapital expenditure will not affect price limits in the current period but will betaken into account in the calculation of the RCV when Ofwat next reviews pricelimits.

3.5.14 Companies should also explain items which may be logged up and items ofdiscretionary expenditure for possible inclusion in the RCV future. Thecommentary should note that these items will require agreement with Ofwat atthe next price setting period.

Movements of periodic review

3.5.15 At each periodic review there may be changes to the opening value of the RCVto take into account certain items which have arisen in the previous price settingperiod. For example:

� Including the net effect of items which have been logged up or logged down.

� Reflecting actual COPI rather than the projection Ofwat made when pricelimits were last set.

� Ensuring an appropriate deduction for any proceeds from land sales made inaccordance with Condition K of companies’ licences.

3.5.16 Where this is the case, companies should explain the movement from theclosing value reported in the prior year to the opening value for the current yearin the note to the accounts. The total amount of such adjustments should bereported together with a description of the adjustments made. The impact ofeach individual element is not required unless there are judged significant intheir own right.


APPENDIX 1

Worked Example

Introduction

This simplified worked example is based on a hypothetical water company. It isintended to illustrate the preparation of CC accounts from HC accounts.For the purposes of cross - referencing, assumptions are denoted [A1], [A2] etc. andcalculations are denoted [C1], [C2] etc.

The note disclosing the RCV has been excluded from this example.

Assumptions

A1 HC Profit and Loss Account

TurnoverOperating costs Operating income

Xxx3£m

450 (288)

3

Xxx2£m405

(247)2

Operating profitOther incomeNet Interest payable

1652

(23)

1551

(61)

Profit on ordinaryactivities before taxationExceptional itemsTaxation - current tax - deferred tax

144(2)

(16)(7)

95-

(10)(5)

Profit after taxation 119 85

Profit for yearDividends

119 (50)

85(30)

Retained profit 69 55


A2 HC Balance Sheet

Fixed Assets Tangible assets Investments

Xxx3£m

15301

xxx2£m

14001

Ref

A3

Current Assets Stocks Debtors Cash at bank & in hand

1531

10822

1401

8751

94 84Creditors; amounting falling duewith one yearBorrowingsDividends payableOther creditors

(85)-

(60)

(55)-

(50)Net Current Assets/(Liabilities) (51) (21)Total Assets less CurrentLiabilitiesCreditors: amounts fallingdue after one yearBorrowingsOther creditorsProvisions for liabilities andCharges: - deferred tax - other provisionsDeferred income

1480

(150)(65)

(12)(5)

(10)

1380

(140)(50)

(5)(6)

(10)1238 1169

Capital and reserves Called up share capital Share premium Profit and loss account Other reserves

770

468

770

399

1238 1169


A3 HC Fixed Assets Note

CostAs at April 1, xxx2AdditionsDisposals

InfrastructureAssets

£m

73070-

OperationalProperties

£m

70075(5)

OtherAssets

£m

5015-

Total

£m

1480160(5)

As at March 31, xxx3 800 770 65 1635

DepreciationAs at April 1, xxx2DisposalsCharge for year

---

70(3)23

10-5

80(3)28

As at March 31, xxx3 - 90 15 105

Net Book ValueMarch 31, xxx3

March 31, xxx2

800

730

680

630

50

40

1530

1400

A4 Third Party Contributions

Note that for the purposes of this worked example, additions to fixed assets areshown net of third party contributions. Assume that the third party contributionsduring the year in question can be summarised as follows: £mOperational assets 10Infrastructure assets 30Other assets -

Total 40

Assume that the third party contributions for operational properties will not start to be offsetagainst depreciation until next year.


A5 RPIAssume that the percentage increase in the RPI is 8 2.5% for the purposes of allcalculations in the illustrated accounts.

A6 Asset DisposalsAssume that the gross replacement cost of disposed assets is £20m and the accumulated CCdepreciation on disposed assets is £12m

A7 Current Cost DepreciationAssume that the current cost depreciation charge for the year is as follows:

£mOperational assets 87


________________________________________________________________________Calculations

C1 CC Profit and Loss Account

xxx3£m

xxx2£m

Ref

Turnover 450 405 A1Current cost operating costs (363) (300) C3Operating income 3 2 A1

90 102Working capital adjustment - - C4Current cost operating profit 90 102Other income 2 1 A1Net interest payable (23) (61) A1Financing adjustment 6 0 C5Current cost profit before taxation 75 42Exceptional items (2) - A1Taxation: - current tax - deferred tax

(16)(7)

(10)(5)

A1

Current cost profit on ordinary activities 50 32Current cost profit attributable toshareholders 50 32Dividends (50) (30) A1Current cost profit retained 0 2


C2 CC Balance Sheet

Xxx3£m

xxx2£m

Ref

Fixed assetsTangible assets 9944 9609 C8Third party contributions (40) - A4

9904 9609Working capital 20 17 C6Net operating assets 9924 9626Cash and investments 3 2Non trade debtors 7 5 C6Non trade creditors due after one year (85) (50) C6Creditors due after one year (225) (200) A2Provisions for liabilities and charges- Deferred tax- Other provisions

-(12)

-(5)

Dividends payable - -Net assets employed 9612 9378Capital and reserves

Called up share capital 770 770 A2Share premium - -Profit and loss 31 31 C1Other reserves - -Current cost reserve 8811 8577 C7

9612 9378

C3 Current cost operating adjustments

Current cost operating costs£m

HC operating costs 288HC depreciation (28)CC depreciation 97HC profit on disposal (2)CC profit on disposal 8

CC operating costs 363

C4 Working capital adjustment

£mOpening working capital 17RPI 0.025

Adjustment <1


C5 Financing adjustment

£m Opening net finance 9378 – 9626 =248RPI 0.025

Adjustment 6

C6 Working Capital

£m NoteStocks 10 HCTrade debtors 75 Other debtors, 7Trade creditors (60) Other creditors, 85Infrastructure renewals accrual (5) Provisions

20

The detailed working capital pro-forma is shown as proforma 11 of RAG3.05.

C7 Movement on current cost reserve

£m

Balance April 1, xxx2 8577

AMP adjustment -

RPI adjustment Fixed assets 240 Working capital 0 Financing (6)

Balance March 31,xxx3 8813


C8 Analysis of fixed assets by asset type (water and sewerage combined)

Infrastructureassets

£m

OperationalAssets

£m

OtherAssets

£m

Total

£m

Ref.

Gross replacement costApril 1, xxx2

7750 2800 100 10650

AMP adjustment - - - -RPI adjustment 194 70 2 266 A5Additions 100 85 15 200 A3Disposals - (20) - (20) A6March 31, xxx3 8044 2935 117 11096Depreciation April 1, xxx2 - 1011 30 1041AMP adjustment - - - -RPI adjustment - 25 1 26 A5Disposals - (12) - (12) A6Charge for year - 87 10 97 A7March 31, xxx3 - 1111 41 1152Net Book Value March31, xxx3

8044 1824 76 9944

Net Book Value March31, xxx2

7750 1789 70 9609

C9 Current cost cashflow

The proforma has not been included for this worked example, but can be found in RAG 3.05 asproforma 6.


APPENDIX 2 Assumptions made in RAG 1.03

The assumptions made in RAG 1.03 fall into two categories, those (here starred) whichare mandatory in the present guidelines and those which are based on materialityconsiderations which may be refutable in specific cases.

ReferenceParagraph

*1 The effect of the regulatory regime on the value tothe business of initial assets can be disregarded. 1.7.6

*2 The RPI provides a better basis for indexing the original 1.9.2September 1997 AMP unit costs to March 1990, than thePPI.

3 Net MEAs are adjusted for the higher operating cost of initial assets. 1.9.6

*4 Modern standards are not below those to which assetswere originally designed. 1.10.2

*5 The deduction in gross MEAs to arrive at original standardsis was the infrastructure renewals backlog. 1.10.2

6 Redundant assets were appropriately reflected in MEAs. 1.10.6

7 Future immediate recognition of redundancies will notmaterially affect profits. 1.10.6

*8 Technical progress is not so rapid as to lead to falls in theMEA values of infrastructure assets. 1.10.7

*10 Initial infrastructure assets would not have been subject tothird party contributions. 1.10.13

11 Future government grants on infrastructure assets are

negligible. 1.10.14

12 In - year RPI indexation of fixed asset additions is immaterial. 1.11.5

13 Assets in use with zero HC net book value have beenvalued at net MEA. 1.11.5

14 Holding gains on stock during the year are immaterial. 1.11.7

15 The CC and HC valuations of closing investments are equal. 1.11.9

16 The CC capitalisation of interest during construction equalsthe HC capitalisation in real terms. 1.11.9


17 The impact of changes in interest rates on the value to thebusiness of financing liabilities can be ignored. 1.12.9

17 If equity is issued during the year, the proceeds will still beheld as cash at the year end. 1.11.11

19 If loans are raised during the year, the proceeds will still be

held as cash at the year end. 1.11.12


APPENDIX 3 Current cost accounting policies

In response to requests from companies Ofwat has prepared the following statementof current cost accounting policies. It is recommended that companies adopt thisstatement to the extent that it is applicable.

Current cost accounting policies

These accounts have been prepared for the Appointed Business of XYZ Limited inaccordance with guidance issued by the Director General of Water Services formodified real terms financial statements suitable for regulation in the water industry.They measure profitability on the basis of real financial capital maintenance in thecontext of assets which are valued at their current cost value to the business with theexception of assets acquired prior to 31 March 1990.

The accounting policies used are the same as those adopted in the statutory historicalcost accounts except as set out below.

Tangible fixed assets

Assets acquired prior to 31 March 1990 and in operational use are valued at thereplacement cost of their operating capability. To the extent that the regulatory regimedoes not allow such assets to earn a return high enough to justify that value, thisrepresents a modification of the value to the business principle. Also, no provision ismade for the possible funding of future replacements of pre – 31 March 1990 assetsby contributions from third parties and to the extent that some of those assets wouldon replacement be so funded, replacement cost again differs from value to thebusiness. Redundant assets are valued at their recoverable amounts.

Modern equivalent asset (MEA) valuation

A review of the MEA valuation and asset stock is undertaken as part of the PeriodicReview. The revised values arising from this review provide the basis for calculatingthe MEA in the current cost financial statements. The process of continuing refinementof asset records has produced adjustments to existing values. The current costdepreciation figures included in the current cost operating costs are based upon therevised MEA values.

Land and buildings

Non - specialised operational properties were valued on the basis of open marketvalue for existing use at {date} and have been expressed in real terms by indexingusing the Retail Price Index (‘RPI') since that date.

Specialised operational properties acquired since March 31, 1990 are valued at thelower of depreciated replacement cost and recoverable amount, restated annuallybetween periodic Asset Management Plan (‘AMP’) reviews by adjusting for inflation asmeasured by changes in the RPI. The unamortised portion of third party contributionsreceived is deducted in arriving at net operating assets (as described below ).


Infrastructure assets

Mains, sewers, impounding and pumped raw water storage reservoirs, darns, sludgepipelines and sea outfalls are valued at replacement cost determined principally on thebasis of data provided by the AMP.

A process of continuing refinement of assets records is expected to produceadjustments to existing values when periodic reviews of the AMP takes place. In theintervening years, values are restated to take account of changes in the general levelof inflation as measured by changes in the RPI over the year.

Other fixed assets

All other fixed assets are valued periodically at depreciated replacement cost.Between periodic AMP reviews, values are restated for inflation as measured bychanges in the RPI.

Surplus land

Surplus land is valued at recoverable amount taking into account that part of anyproceeds to be passed onto customers under Condition B of the Licence.

Grants and other third party contributions

Grants, infrastructure charges and other third party contributions received since 31March 1990 are carried forward to the extent that any balance has not been credited torevenue. The balance carried forward is restated for the change in the RPI for the yearand treated as for deferred income.

Real financial capital maintenance adjustments

These adjustments are made to historical cost profit in order to arrive at profit after themaintenance of financial capital in real terms.

Working capital adjustment

This is calculated by applying the change in the Retail Price Index ('RPI') over the yearto the opening total of trade debtors and stock less trade creditors.


This is calculated by applying the change in the RPI over the year to the openingbalance of net finance which comprises all monetary assets and liabilities in thebalance sheet apart from those included in working capital.


APPENDIX 4 Acronyms

AMP Asset Management Plan ASB Accounting Standards Boards ASC Accounting Standards Committee CC Current Cost CCA Current Cost AccountingCOPI Construction Output Price Index CPP Constant Purchasing Power ENGE Enhancement, New, Growth and Efficiency Capital Expenditure FCM Financial Capital Maintenance FRS Financial Reporting Standard HC Historical Cost HCA Historical Cost Accounting IRC Infrastructure Renewals ChargeIRE Infrastructure Renewals ExpenditureMD letters Letters to Managing Directors of water & sewerage & water only

companiesMEA Modern Equivalent Asset NBV Net Book ValueNPV Net Present Value OCM Operating Capability Maintenance P&L Profit and Loss Account PPI Producer Prices construction output IndexPR99 Periodic Review 1999RAG Regulatory Accounting GuidelinesRCV Regulatory Capital Value

RPI Retail Price Index SSAP Statement of Standard Accounting Practice STRGL Statement of Total Recognised Gains and LossesWASC Water and Sewerage Company WGAR Working Group on Accounting Issues for Regulation WOC Water Only Company


APPENDIX 5 Bibliography

1 SS AP 16, Current Cost Accounting, ASC, 1980.

2 FRS3 Reporting financial performance, ASB, June 1993.

3 FRS10 Goodwill and intangible assets, ASB, December 1997.

4 FRS12 Provisions, contingent liabilities and contingent assets, ASB, September1998.

5 FRS15 Tangible fixed assets, ASB, February 1999.

6 Carsberg & Lumby, The Evaluation of Financial Performance in the WaterIndustry: The Role of Current Cost Accounting, CIPFA, 1983.

7 Tweedie and Whittington, The Debate on Inflation Accounting, CambridgeUniversity Press, 1984.

8 Accounting for the effect of changing prices: a Handbook, ASC, 1986.

9 Accounting for Economic Costs and Changing Prices, HMSO, 1986.

10 BAWING Report, Department of the Environment (unpublished), 1987.

11 Edwards, Kay & Mayer, The Economic Analysis of Accounting Profitability,Clarendon Press, 1987.

12 Framework for the Preparation and Presentation of Financial Statements, IASC,1988.

13 Infrastructure Accounting, Water Services Association, 1989.

14 The Future Shape of Financial Reports, joint Action Group of the ICAEW Boardand the ICAS Research Committee, 1991.

guideline for accounting for current costs and …

Documents